The markets got to hear a handful of the major investment banks step to the mike last week and announce their earnings for the fiscal third quarter. Because of the turmoil that has shaken markets as of late, the announcements took on more significance than usual as investors looked to the group as a barometer for how the mess is being digested.
The results from the four banks -- Lehman Brothers
Investment banking -- comprising financial services and debt and equity capital raising -- was overall an area of notable strength for the banks. Financial advising was a particular strength as merger and acquisition pipelines built up over a very active first half of the year continued to close. Equity capital raising, which is mostly IPOs and secondary offerings, was softer than it was in the second quarter, but still pretty strong compared to last year. Not surprisingly, the debt capital raising was much softer as the turmoil in the credit markets put on the squeeze.
Going forward, big question marks have been raised. M&A in particular has been under the interrogation light since it was such a notably strong area across banks for the quarter. Goldman Sachs' CFO David Viniar spoke specifically to this and said that he sees continued global growth as a catalyst for continued banking activity, and also noted that though financial sponsors have taken a breather from the frenetic activity in the beginning of the year, they still have a significant amount of cash that they need to invest. Lehman Brothers' CFO likewise expects that M&A activity will finish the year 15%-20% higher than in 2006.
Trading and capital markets
This segment was a big mess overall, and much of the deep red that investors were expecting showed up in this part of the business.
In equities, derivatives, commodities, and currencies, trading volume was higher during the quarter as market volatility spiked. This was good news for the banks as they cashed in on fees and commissions for executing the trades. Principal strategy trading on the equity side was also mostly positive, with the exception of Morgan Stanley. Morgan disclosed that it had lost $480 million during the quarter from poor performance of its quantitative trading strategy -- a fate that many hedge funds suffered, but which didn't have a material impact on the other banks.
For obvious reasons, fixed-income trading was a notable black mark on the results for the banks. Across the board, the banks suffered from lower client volumes and big write-downs of asset values. During the quarter, Goldman wrote down an impressive $1.7 billion on some loans it had originated for noninvestment grade securities. Lehman Brothers and Bear Stearns took similar hits of $700 million, net of hedges, each, while Morgan Stanley recognized a $940 million knock. Of the group, Goldman was the most aggressive about trying to counteract the suffering mortgage market, and disclosed that it was able to more than offset losses from subprime loans by shorting mortgages.
Looking toward next quarter, if market volatility continues at currently high levels, the banks could really bring home the bacon from execution fees and commissions. Should the fixed-income markets loosen back up a bit, that also would provide a big boost. And while prop trading strategies are very difficult to project, it seems likely that Morgan won't have another big hit from its quant trading desk.
For three out of the four banks, asset management was another area -- along with investment banking -- that helped offset some of the big bumps in the road. Goldman Sachs, Lehman Brothers, and Morgan Stanley all saw strong net inflows of capital during the period which led to high management fees. Though Goldman has seen tough times at its hedge funds, and incentive fee income continues to be depressed, it didn't have a major impact on its asset management business for the quarter.
Bear Stearns, of course, was the standout for blowing it on the asset management side during the quarter. While there were some positives for the segment at Bear, they were all overshadowed by the big losses that it took from the two hedge funds that it had to shut down during the quarter.
Looking out, it seems reasonable to expect that the three banks that had a good quarter here will continue to do so. Goldman needs badly to get its hedge funds back on track, but that could be seen as a kicker for the division. Bear may sputter for a couple of quarters getting its asset management business back on track, but this quarter should be the most painful for it in that business.
Although this is not a business segment per se, more than one of the banks noted the strength of their overseas business and how important it was to balance out the weakness in the U.S. during the quarter. Lehman Brothers had a whopping 53% of its revenue come from outside of the U.S. during the quarter. The Asia-Pacific region was of particular strength, where revenue was up 79% versus the prior year. Goldman noted a similar percentage of its revenue from international business, and Bear Stearns also highlighted strong performance from abroad.
With or without a tough environment in the U.S., expect to see the banks continue to aggressively grow their businesses overseas and take advantage of the strong growth and corporate activity going on.
The Foolish final word
You do not want to have a large piece of your portfolio hitched to the Good Ship Investment Banking should the threat of a recession prove real. Keep an eye on this group, though, because though they may continue to get cheaper now, you can bet they'll be rushing back in a big way during the next big bull run.
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